Historically, the
yield curve spread, or the difference between short-term and long-term
interest rates, has had some predictive power for the performance of
the U.S. economy and banking industry. In the past, a narrowing, or
flattening,
of the spread has tended to foretell both slower economic growth and
increased pressure on bank earnings. Furthermore, the yield curve
generally has
inverted—a condition where short-term rates exceed
long-term rates—up to two years ahead of a recession. Based on this
historical context,
the
flattening in the yield curve since mid-2004 has been on the minds of
many economists and banking analysts. Sometimes, however, the yield
curve flattens
or inverts for reasons that may not necessarily foreshadow slower economic
growth.

The shape of the yield curve spread also has held implications for bank margins and profits. Historically, bank net interest margins have tended to decline one to two quarters after a decline in the yield curve spread. While many banks have found ways of reducing their sensitivity to changes in yield curve spreads in recent years, the largest banks have seen their margins squeezed substantially by the recent flattening in the yield curve. And although smaller banks have been less affected so far, the earnings of all lenders will likely be affected should the yield curve remain flat for several more quarters. This issue of FYI examines the historical relationships of the yield curve with economic growth and how changes in the spread have affected banks.

The
Yield Curve and the U.S. Economy

A
yield curve is simply a graph depicting the yields of similar debt instruments
of differing maturities. There are many yield curves and many ways of
measuring the difference, or spread, in short- and long-term interest
rates along these curves. A common measure of this difference is the
spread between the federal funds rate, which is set by the Federal Reserve
and
used in pricing overnight interbank loans, and the 10-year Treasury note
yield, which is linked to the pricing of traditional fixed-rate mortgages.
Two other common measures of the spread take the difference between 3-month
and 10-year Treasury yields or the difference between 2-year and 10-year
Treasury yields. Some research indicates that calculating spreads using
very short-term rates, such as the federal funds rate or 3-month Treasury
yield, is a more useful indicator of future economic activity than using
a 2-year Treasury yield as a short-term rate.1
In keeping with this prior research, we will focus on the spread between
the federal funds rate and the 10-year Treasury yield when measuring
the
shape of the yield curve.

Inverted
Yield Curves Sometimes Precede RecessionsHistorically, the
shape of the yield curve has been a useful leading indicator of economic
growth. For instance, the beginning of a recession has seldom followed
a period with a steep (positively sloped) yield curve within two years
(see Chart 1). In fact, during months in which the spread has measured
at least 200 basis points (2 percentage points), a recession has ensued
within two years only 5 percent of the time. The shape of the yield
curve has also told us when recessions may be more likely. In Chart
1, we see that the yield curve has inverted significantly, or by at
least 100 basis points, within two years prior to each of the past
six
recessions.

However, the slope
of the yield curve does not have a perfect track record when it
comes
to foretelling the future. Chart 1 shows that the yield curve did not
invert before the two recessions that occurred in the late 1950s
and
early 1960s, a period when long-term yields were exceptionally low,
as they are today. The inverted yield curve during 1966, the near-inversions
in both 1987 and 1995, and the inversion in 1998 are also examples
of inaccurate growth signals. Surging job growth and falling unemployment
contributed to a spike in inflation in 1966. As the Federal Reserve
decreased money supply growth in response, the effective federal
funds
rate rose and the yield curve inverted briefly between mid-1966 and
early 1967. The near-inversion in 1987 occurred during the stock
market
crash that year, known as Black Monday. The near-inversion during the
mid-1990s reflected an economic soft patch that followed a 3 percentage
point increase in the federal funds rate over a 13-month period. And,
the inversion in 1998 came during the financial market turmoil surrounding
the collapse at Long-Term Capital Management. These episodes passed
without any recession beginning in the next two years. What this
tells
us is that a flattening yield curve may be a necessary, but not a sufficient,
condition for recession.

The
Yield Curve Can Invert for Reasons Not Related to Future Economic
GrowthWhile inversions
of the yield curve spread generally precede a recession, the yield
curve
can also invert for reasons not related to slower economic growth.
Historically, short- and long-term yields tended to move in the same
direction, but
since the 1990s this relationship has been disappearing. More recently,
between June 2004 and January 2006, the Federal Reserve gradually
increased
its target federal funds rate by 350 basis points, from 1 percent to
4.5 percent.2 Yet over the same period,
10-year Treasury yields fell from 4.7 percent to 4.5 percent, which
resulted in a pronounced flattening of the yield curve (see Chart 1).
The relatively stable and low level of long-term interest rates in
the
presence of strong economic growth and rising short-term interest rates
has been somewhat of a mystery to economists, even prompting former
Federal Reserve Chairman Alan Greenspan to famously label their behavior
a "conundrum."3 Several
explanations have been suggested for the flattening of the yield
curve during the
past two years.

Low
Term PremiumFirst,
some have speculated that increased stability in global financial
markets has resulted in a low term premium. The term premium is the
additional yield required by investors for purchasing long-term
securities.
To compensate for the fact that an investor is exposed to more risks
over a 10-year investment horizon relative to a 3-month investment
horizon, yields on longer-dated securities tend to be greater than
the yields on similar, but shorter-dated, securities. Research by
the Federal Reserve indicates that investors may have become more
willing to invest long term in recent years, perhaps encouraged
by
recent stability in economic conditions and financial markets.4
Alternatively, financial market innovations such as derivatives may
provide investors the means to reduce long-term investment risk.
As
a result, increased demand for long-term securities has
caused yields on these securities to fall.

Low
Inflation ExpectationsSecond, the flatness
of the yield curve could be due to the easing of long-term inflation
expectations, which are an important component of the term premium.
Since inflation erodes the future value of an investment, investors
require an inflation premium in the form of higher long-term interest
rates to compensate for this lost value. However, according to the
Philadelphia Fed survey of professional economic forecasters, long-term
inflation expectations have steadily declined over the past 10 years.
If market participants expect inflation to remain low in the future,
then they will require a lower inflation premium to compensate them
for future inflation.

Demand
from Foreign Central BanksThird,
foreign central banks have continued to maintain strong demand for
U.S. securities, especially long-term Treasuries. Central banks in
Japan, China, and Europe have been major purchasers of Treasuries
and have generally purchased Treasury notes and bonds rather than
short-term bills.5 For example,
at the end of 1999, China held $52 billion worth of U.S. Treasury
securities.
By November 2005, China’s holdings of these securities totaled
$250 billion, an increase of nearly 400 percent. Similarly, Japan
increased its holdings from $320 billion at year-end 1999 to $682
billion by November 2005. Central banks in many large European countries
also have increased their holdings of U.S. Treasury securities. This
steady source of demand has, by supporting the price of Treasury
securities,
kept a lid on long-term interest rates.

Investment
Activities by Pension Funds and Hedge FundsFourth,
investment activities by pension funds and hedge funds could be
depressing
long-term yields. Pension funds across the United States and Europe
have increasingly sought to match the durations of their liabilities
with their assets.6 Given the long
durations of pension liabilities, many funds have sought to invest
in long-term Treasury bonds to better match the timing of their future
liabilities. Hedging and investment activities by funds and corporations
have tended to flatten the yield curve as well. For example, many
hedge funds may take positions in long-term U.S. Treasury securities
in order to execute investment strategies, thus generating extra
demand.7

Although these explanations clarify why long-term interest rates
have remained comparatively low, their influence is hard to isolate
from
investor concerns about a possible slowdown in economic growth. It
is important to understand the reasons why the yield curve flattens
or inverts so that we can fully grasp its predictive power as a leading
economic indicator. Because of our uncertainty, it is essential
to
view the yield curve in conjunction with other economic and financial
statistics to avoid misreading the tea leaves. At this time, other
leading economic indicators are not raising recession concerns.8

The
Yield Curve and Banks

Just as the yield
curve is not a perfect indicator of future economic growth, it also does
not
provide perfect foresight as to how bank net interest margins (NIMs)
and earnings will fluctuate. The traditional view of the banking business
holds that banks pay interest on their deposits based upon shorter-term
interest rates while making loans tied to longer-term interest rates.
Thus, the difference between interest paid and received—the margin—should
be influenced by the slope of the yield curve. There is some empirical
support for this view. For instance, Chart 2 shows that, until recently,
overall bank NIM declined over a period of three to six months following
a drop in the yield curve spread.

The fairly
tight correlation between changes in the yield curve and NIMs, however,
generally held true only through the mid-1990s. It has weakened since
then. The correlation between changes in the yield curve
spread and bank NIMs with a two-quarter lag was 70 percent between 1984
and 1994. Since 1994, the correlation has fallen to negative 17 percent,
suggesting that there has been very little systematic relationship
between
NIMs and changes in the yield curve spread over the past decade. For
example, since the yield curve began to flatten during mid-2004, NIMs
at FDIC-insured
institutions have risen from just under 4.00 percent to 4.14 percent
in third quarter 2005.

Some analysts
assert that bank earnings have become less sensitive to changes in
the
slope of the yield curve. Recent FDIC research finds that banks react
differently to changes in interest rates based on their asset size
and
their ability to offer various types of customer products.9
International research supports this finding. Banks in major industrialized
countries have become better able to shield themselves against adverse
changes in the slope of the yield curve over time.10
As a result, the yield curve appears to have lost some of its usefulness
as an indicator of the banking industry’s overall health and profitability.

Large
Bank Net Interest Margins Have Been Squeezed by the Flat Yield CurveA flat or inverted yield curve spread
can impact individual banks in different ways. For example, looking
at Chart 3, we can see that median NIMs have behaved differently based
on bank size. Since mid-2004, the median NIM for banks with total assets
over $10 billion has fallen in tandem with the flattening yield curve,
while those for institutions with total assets under $10 billion have
increased. But why have only the largest banks responded in typical
fashion to a flatter yield curve? Chart 4 adds some insight to this
disparity. The median yield on assets at banks exceeding $10 billion
in size has consistently been about 50 basis points below that of smaller
banks since 2004. At the same time, the relative cost of funding those
assets at the largest banks has risen faster over the same period. As
a result, median large bank NIMs have been compressed relative to their
smaller peers. These two aspects are discussed in more detail below.

Yields
on Assets Have Been Lower for Large BanksIn
2000, banks in varying size groups had similar median asset yields,
but the rate of decline in asset yields between 2001 and 2003 was
the greatest for the largest institutions. Further, these large institutions
have been slow to close the resulting gap since yields began to rise
again in 2004. This may be due to the fact that larger banks have
a different asset composition than smaller banks. For example, large
banks tend to have higher concentrations of commercial and industrial
(C&I) loans and credit card receivables. The C&I lending environment,
especially for large loans exceeding $1 million, has been very competitive
in recent years.11 Not only do banks
compete against other banks, but they also compete against capital
markets, which have become a popular source of funding for corporations.
Lending standards, and particularly the rates charged on business
loans, have generally fallen because of this highly competitive environment.
In addition, many corporations have experienced increases in their
cash balances in recent years, creating less incentive to reach out
to banks for financing. This strong corporate cash position has weighed
on C&I loan growth. Thus, it is likely that weaker pricing and
volume growth have together caused the median asset yield at large
commercial lenders to lag behind that of their smaller peers.

Funding
Costs Have Risen More Quickly for Large BanksThe second factor that explains why large
and small bank NIMs have behaved differently concerns the cost of
funding assets. Chart 4 indicates that funding costs at large banks
were below that of small banks between 2001 and 2003. However, since
early 2004, funding costs at large banks have risen much faster relative
to small banks. Large banks have a greater reliance on overnight and
wholesale funding than smaller banks. These funds tend to reprice
faster than longer-term deposits, such as certificates of deposit
and money market accounts, when short-term interest rates rise. As
a result, smaller institutions may be able to reprice their deposits
at a slower rate relative to larger institutions, thus preserving
(and even boosting) their margins, at least for a time.

Banks
Have Reduced Their Exposure to Changes in the Yield CurveMajor
changes in the past two decades have greatly reduced the effect of shifts
in the yield curve on banks. Changing banking regulations, product differentiation,
new asset/liability management practices, and increased use of non-interest-bearing
funding sources have helped financial institutions mitigate the yield
curve’s effects on profits.

Changing
Banking Regulations Have Allowed Banks to Find New Sources of
IncomeDuring
the 1980s, the banking industry went through a series of structural
changes that had meaningful economic and financial impacts.12
The Depository Institutions and Deregulation and Monetary Control
Act of 1980 allowed banks to pay interest on time and savings deposits,
expanded lending and investment powers for institutions, and removed
restrictions on statewide banking. In 1982, the Garn–St. Germain
Depository Institutions Act increased loan limits and removed restrictions
on the ability of national banks to make real estate loans. Interstate
banking and interstate branching were fully adopted through the
Riegle-Neal
Interstate Banking and Branching Efficiency Act of 1994. More recently,
the Gramm-Leach-Bliley Act of 1999 removed restrictions on the
mergers
of banks, insurance companies, and brokerages. Together, these changes
allowed banks to develop a vast array of customer products beyond
traditional lending services. As a result, the makeup of bank revenues
has changed since the 1980s (see Table 1). Non-interest income
has
become a larger factor in total income, especially since 1990. The
importance of non-interest income has been more noticeable for
larger
banks with assets exceeding $1 billion.

Table
1

Non-interest
income has become a more important source of earnings, especially
for larger
banks.

Ratio
= Non-Interest Income / (Non-Interest Income + Interest Income)

Bank
Size

1985

1990

1995

2000

2005

Under
$100 Million

5.2%

5.7%

7.3%

6.7%

9.1%

$100 million
to $1 billion

6.4%

5.8%

8.1%

7.9%

10.8%

$1 billion
to $10 billion

8.9%

9.4%

12.8%

10.8%

14.1%

Over $10
billion

9.7%

11.9%

17.9%

19.8%

25.1%

Ratio is year-end median data
for each asset size group.
Source:FDIC

Product
Differentiation Has Allowed Banks of All Sizes to Increase Non-Interest
Income
Although the largest banks have traditionally benefited most from
non-interest income, this trend may be changing. Increased telecommunication
speeds and the development
of new information technologies have reduced the cost of offering
new products to customers for banks of all sizes. These technologies
also allow bankers to maximize fee-based revenues across a diverse
customer base. In recent years,
smaller banks have increasingly sought to diversify into non-traditional
banking services. In part because of cheaper and better technologies,
some small- and medium-sized lenders have expanded their product
mix to include insurance and investment activities, further diversifying
their sources of non-interest income.

New
Asset/Liability Management Techniques Have Helped Reduce the
Risks
of Changes in the Yield Curve SpreadOn
top of an increased reliance on fee and other non-interest income,
banks have additional means to reduce the impact of yield curve changes
on profits. For example, many banks, especially the large ones,
have
been able to hedge their interest rate exposure by using derivatives
such as interest rate swaps.13 Banks
have also been able to reduce the effect of interest rate moves
by
directly selling their fixed-rate loans to investors or by securitizing
the loans into financial instruments such as mortgage-backed securities.
Further, banks have been able to more narrowly adjust the costs and
durations of deposits and loans. Federal Home Loan Bank advances
have
provided banks a flexible source of fixed-rate funding with average
durations exceeding that of their core deposits. Access to these
alternative
funding sources has helped insulate bank funding from interest rate
shifts, as traditional deposits may be more exposed to the risks
of
short-term interest rate volatility. On the asset side, banks have
been increasingly offering variable-rate loans, such as adjustable-rate
mortgages (ARMs), where in the past they may have only offered loans
tied to a long-term fixed rate. Since ARMs reprice faster than
traditional
fixed-rate mortgages, NIMs may not contract by as much as they otherwise
would when the yield curve flattens.

Use
of Non-Interest-Bearing Liabilities Has Helped Support Net Interest
MarginsFinally,
greater use of non-interest-bearing funding sources, such as demand
deposits and equity, may be supporting NIMs. Chart 5 divides NIM
into two separate components to help explain why margins have risen
despite
a flattening yield curve.14 The
first component, the NIM on interest-bearing liabilities, is the
net return
on assets funded by interest-bearing liabilities (for example, certificates
of deposits and money market accounts). In essence, this component
represents the traditional view of the banking business. Since 2001,
the NIM on interest-bearing liabilities has steadily weighed on
net
interest margins as the spread between the prices paid on liabilities
and the yield received on assets narrowed.

The
second component of NIM, the NIM on non-interest-bearing liabilities,
is the net return on assets funded by non-interest liabilities (for
example, equity and demand deposits). Because
market rates on assets increased and these liabilities carried no
explicit interest cost, this component helped to offset the reduction
in overall NIMs resulting from the first component. Thus, banks may
have been able to offset at least some of the compression in the
total
NIM by funding more of their assets through non-interest-bearing
liabilities. In particular, corporate demand deposits that would
normally be swept
into interest-bearing, non-deposit investments have accumulated on
bank balance sheets during a period of historically low short-term
interest rates. But as is evident in the scales of the two charts,
the overall industry impact has been small. The share of NIM tied
to non-interest-bearing liabilities has only risen to 24 percent,
from 18 percent in 2003, accounting for an increase in NIMs of
only
17 basis points versus a drop of 26 basis points in the NIM associated
with interest-bearing liabilities.

History suggests that the odds of recession increase
when the yield curve spread flattens or becomes inverted. But past recessions
only occurred with a high frequency after the curve inverted by a significant
amount for a sustained period of time. Further, the yield curve spread
can invert for reasons other than the possibility of slower economic growth.
We have presented some of these possible explanations, which include expectations
of lower long-term inflation, a recent reduction in the term premium,
strong demand for longer-term debt by foreign central banks, and investment
activities by pension and hedge funds. As a result, the flat yield curve
spread may not be signaling increased odds of a recession at present.
By the same token, the structural forces holding long-term interest rates
down may be with us for some time, even as the cyclical increase in short-term
rates subsides. The presence of these structural forces suggests that
a flat yield curve could persist for some time.

Similarly
for banks, flat or inverted yield curves have historically been associated
with narrowing NIMs and lower earnings. Many smaller banks thus far have
been able to insulate themselves from changes in the yield curve spread,
because they have only slowly raised the interest rates they pay on their
liabilities. In contrast, the largest banks have seen their liability
costs rise more rapidly, while at the same time their asset yields have
lagged those for smaller banks. This situation has resulted in a classic
margin squeeze for the largest banks as the yield curve has flattened.
Even so, it may be just a matter of time before margins for smaller banks
begin to be squeezed, especially if the flat yield curve persists. Regardless
of the slope of the existing yield curve—positive, flat, or negative—bankers
will benefit from strategies designed to cope with the uncertainty of
changing interest rates.

2
Statements from the Federal Open Market Committee indicate that the committee
began to raise its target interest rate in June 2004 to remove accommodative
monetary policy. See: http://www.federalreserve.gov/fomc/.

7
This extra demand is evidenced by strong demand of U.S. Treasuries by
Caribbean banking centers, which some analysts believe largely consist
of offshore hedge funds. Some of these hedge funds may be engaging in
the carry trade, which involves taking a long position in a long-term
Treasury security while simultaneously taking a short position in a short-term
Treasury security.

8
For example, the Economic Cycle Research Institute’s weekly leading
index moved higher in January, and the Index of Leading Economic Indicators,
which includes the yield curve spread as one of its components, was not
signaling recession in late 2005.

10
For example, banks have adopted new ways of selecting assets and liabilities,
modifying the manner in which they set rates on core deposits and
retail
loans, and engaging in hedging activities. See: William B. English, “Interest
Rate Risk and Bank Net Interest Margins - PDF,” Bank of International
Settlements Quarterly Review, December 2002. 836k (PDF Help)

13
While almost 900 institutions report holdings of derivatives, the vast
majority of these holdings are at banks with assets over $10 billion.
See: FDIC
Quarterly Banking Profile, Federal Deposit Insurance Corporation,
Third Quarter 2005.

14
This analysis updates work originally published in: “Profits and
Balance Sheet Developments at U.S. Commercial Banks in 2003,” Federal
Reserve, Federal Reserve Bulletin, Spring 2004.

About
the AuthorNathan
Powell is a Financial Economist in the Economic Analysis Section of the
Division of Insurance and Research, FDIC.

Comments
and InquiriesSend
comments or questions on the FYI to Norm Williams nwilliams@fdic.gov

Send feedback and technical questions about the FYI series to:fyi@fdic.gov

All media inquiries should be addressed to: David Barr, FDIC Office of Public
Affairs, dbarr@fdic.gov

About
FYIFYI
is an electronic bulletin summarizing current information about the trends
that are driving change in the banking industry, plus links to the wide
array of other FDIC publications and data tools.

DisclaimerThe views
expressed in FYI are those of the authors and do not necessarily
reflect official positions of the Federal Deposit Insurance Corporation.
Some of the information used in the preparation of this publication was
obtained from publicly available sources that are considered reliable. However,
the use of this information does not constitute an endorsement of its accuracy
by the Federal Deposit Insurance Corporation.